RSI as a Great Overbought Oversold Indicator

“Overbought” and “Oversold” are the terms we use in our analysis and articles very often. I am usually asked what do I mean by “overbought” and “oversold”. I searched and found out that there was only a small and defective article about these important terms on LuckScout, so that I decided to write a more detailed article about this topic to help traders understand what these terms are exactly.

There are some too technical definitions for overbought and oversold over the Internet. I am going to simplify them as much as possible and tell you that the market is overbought when a few (3 to 5) relatively strong bullish candlesticks are formed, and is oversold when a few relatively strong bearish candlesticks are formed.

I am going to show you how RSI determines that a market is overbought and oversold. Novice traders can add this indicator to their charts and see how it works. Later in this article I will tell you that although having a good indicator like RSI is a big help to confirm the trade setups we locate, we don’t have to have it on our charts, because candlesticks tell us everything we need to determine whether a trade setup is good and strong or weak and questionable. Additionally, you will see that RSI is not able to warn us in advance, if a market wants to go against us and hit the stop loss even after a too strong trade setup.

I have already published a few articles about RSI on LuckScout. I recommend you to read them to know what RSI is and how it works:

RSI is a good indicator in general. Although I don’t use it personally, if I wanted to use an indicator one day, it would be RSI and MACD. Read the above articles and you will know why.

The other thing you have to take into consideration is that when we say a market is overbought, it doesn’t mean that it will reverse and go down. It can keep on going up for such a long time, even when it is overbought. Similarly, price can keep on going down when it is oversold, and being oversold doesn’t mean that it will reverse and go up.

Does it means that we can buy even when the market is overbought, and sell even when the market is oversold?

If we do it when we are at the beginning of an uptrend, then the answer is yes. When an uptrend is started, the market becomes overbought after forming a few bullish candlesticks, but then it will keep on going up, and it forms an uptrend. Some bearish candlesticks also form, but they can not take the price down and make the market oversold, and the uptrend will be continued. Therefore, if you know that you are at the beginning of an uptrend, and so you enter the market, you will make a lot of profit.

It is also the same when the market is oversold. We can go short when the market is oversold, and the price will keep on going down in case we are at the beginning of a strong downtrend. The only thing we need is that we know whether we are at the beginning of a downtrend while the market is oversold or not.

With DBB Trading System, usually we go long when the price has already moved up a lot and the market is already overbought. That is why I always say that trading is not about buying low and selling high. In most cases it is buying high and selling higher.

In our regular trading system (candlestick patterns + Bollinger Bands), we usually enter sooner when the market is not overbought or oversold. However, as we only take the too strong trade setups, we can catch a trend while we are already in. We find out that we are riding a trend usually when the price breaks above a resistance (in case of an uptrend), or below a support (in case of a downtrend), while we have already taken our positions based on a too strong candlestick pattern. I will show you the examples later in this article.

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RSI Is A Good Overbought Oversold Indicator

Add RSI to EUR/USD daily chart and set it to 9. RSI default setting is 14, but we set it to 9 to have sharper highs and lows.

There are three horizontal lines or levels on RSI indicator window: 30, 50 and 70

Market is considered overbought when RSI breaks above the 70 level, or keeps on moving around it, or above the 50 and below the 70 levels:

Market is considered oversold when RSI breaks below the 30 level, or keeps on moving around it, or below the 50 and above the 30 levels:

How Does This Help Us Trade?

I know you are saying, “so what? Let’s say we learned what RSI overbought and oversold mean. Can it help us trade and make some money? Can it helps us enter the market with a better price? Can it help us take stronger trade setups and avoid the weak ones?”

It is a big help and confirmation for the trade setups, both with our regular candlestick pattern + Bollinger Bands system and also with DBB System. However, it is not necessary to have it on the charts. Let me show you some examples.

With our candlestick pattern + Bollinger Bands system, usually the too strong short trade setups form when RSI has already broken above the 70 level sharply, but when the short trade setup forms (for example when the second candlestick closes in a too strong Bearish Engulfing Pattern), RSI also breaks below the 70 level.

What does this RSI strong reaction mean?

It means the market has become too overbought, and it was the time for bulls to take a break, because they are exhausted. Now, if a too strong bearish reversal pattern, like a too strong Dark Cloud Cover or Bearish Engulfing Pattern forms, it means bulls want to give the control to bears.

The below screenshot is showing you 4 good examples at the same time. The first three (at the left side of the chart), are weak short trade setups and the last one is a too strong short trade setup. With the first three setups, although RSI had broken above the 70 level, the candlestick patterns are not too strong by themselves. Therefore, they have to be ignored. With the last trade setup, RSI has not only broken above the 70 level more strongly and sharply, but also the Bearish Engulfing Pattern formed by 2013.02.04 candlestick is too strong. Therefore, this is a too strong short trade setup while the market is strongly overbought:

As I mentioned earlier, we enter the market based on a DBB system trade setup usually when the price has already moved a lot. DBB system is good when we miss a trade setup formed based on our regular candlestick pattern Bollinger Bands system, because it shows us another chance to enter the market.

As I mentioned earlier, the price can go much higher, when the market is already overbought, and visa versa. Usually when a DBB long trade setup forms, the market is already overbought. The below screenshot is related to a recently formed DBB long trader setup on GBP/JPY daily chart, while a too strong long trade setup was already formed on the weekly chart, based on our regular trading system. The DBB long trade setup on the daily chart, was a good chance to go long, for those who had missed the weekly long trade setup (to learn more about this trade setup please read the related posts here).

As you see on the below chart, candlestick #3 formed a DBB long trade setup while RSI was so close to the 70 level. And when the next candlestick opened (which is actually the right time to go long after the DBB setup was formed), RSI also broke above the 70 level. As you see, the price went up strongly while the market is too overbought. It is possible that it goes even higher:

Conclusion

You go long based on the Candlestick Bollinger Bands system when the price is already oversold, and you go short when the price is already overbought.

You go long based on the DBB system when the price is already overbought, and you go short when the price is already oversold.

What does it mean?

To take a position, you need a too strong and good trade setup. It doesn’t matter if the market is overbought or oversold. When there is no trade setup based on any of our trading systems, it is risky to go long when the market is overbought, and it is risky to go short when the market is oversold, because the price can reverse at any time.

Also when there is no strong trade setup based on any of our systems, it is risky to go long when the market is oversold, because it can keep on going down. It is also risky to go short when the market is overbought, because it can keep on going up.

It is only a too strong trade setup based on the only real time indicators (candlesticks), that tell you whether you should go short or long. As an overbought and oversold indicator, RSI can only be used to confirm a trade setup, but if you really take the too strong trade setups, you don’t have to get any confirmation from RSI. The price can still go against you, even when RSI has already confirmed the trade setup. The only thing that can save us from losing money, and help us have more winning trades is the candlesticks that are the only real time indicators.

I can see a strong short trade setup forming for NZDJPY. There was a good breakout from yesterday’s candle and there is a good breakout from today’s bearish candle with a long tail. The price seems to have turned at a resistance level at 88.97.

The only downside I can see is that it’s in a bull trend for the last few days.

Like many others i supose i’m still long in AUD/JPY.
I know we have to wait for the candlestick to close,but if he closes like a bearish engulfing should that be a reason to close the position or to move up or SL for example?Or is the strong weekly set up strong enough to stay in?

Thank you Chris,
You’re teaching us in great way and with a lot of patience how to find strong set ups to enter the market, and the checklist you made was also a great idea! However,i find it very dificult to decide when to get out to maximize profit.I still have to learn a lot about that. I think it is also very important and hope you can learn us how to handle that.

Chris, thanks for helping us focus on more subtle aspects of engulfing setups.

Regarding the long tail on USD/CHF (11/4), a question: The bearish tail was about 26% of the length of the candle body (no bullish tail).

If the tail had been 10% or 5% of the body, would that have made this a 90-95 set-up, other things being equal? Since tail length must be viewed in regard to overall candlestick length, a rule-of-thumb would be very useful.

Thank you for the market analysis and advice us to remind patience to wait for the too strong trade. As you said its great for the long run.

1. Found a short trade (dark cloud cover) on daily GBPCAD at 2014.11.05. Although both candles breakout the upper Bollinger Band, I think it’s not a strong trade. As you said, the lower tail should not be ignored. Its tail is almost a half of its body, besides there’s relatively 3 big bullish candles before.

2. AUDUSD is making noise for sometimes, but current bullish candle has broke the 0.86427 resistance level. I think it will continue its bearish trend.

Hi Chris
Apologies for my late response sometimes, difference in time zone.
I have a few questions regarding trade management
1) When 2 positively correlated currency pairs give a 100 score, how do you play such scenario, would you split risk between both set ups i.e half your original risk on each or you would trade both with full risk each or you would pick one and ignore the other?
2) My 2014/10/21 GBPCAD was taken out at BE. I’d like to know at what level do you move your stoploss to BE
3) Do you ever use logical support and resistance level for profit taking, BE or trailing stops?
Sorry bout the long questions Chris, just curious

Chris,
One more time thank you for your articles. You are doing amazing work.
Looking at your screenshots and my charts, I can see that there are some differences in the candlesticks. I have read in some of your replies to comments (older articles) that this is due to the different time zone that different brokers use.
Does this mean that if we are trading with a different time zone, our candlesticks (daily for example) will close at a different time? Because if they close at the same instant, shouldn’t they be identical?
Sorry if this is a silly question but I think I am a bit confused.
Thank you.

Yes, it is a strong resistance level at 101.04. However, as long as we don’t know what reaction the price will show to this level we can not do anything. We can not go short just because the price has reached a resistance level. What if it wants to break above the resistance? We can go short if it forms a strong short trade setup below the resistance.

I was short on G/CAD due to too strong short set up formed on 20.10.14 but my SL was triggered on 03.11.14 and re-entered at the close of the candlestick. Is this a right approach because I know that the bearish engulfing pattern formed on 20.10.14 was a strong trade set up.

Hi Chris, your analysis and comments are always very valuable. Although a novice trader might know basic rules for strong trade setups, there are still a lot of details on everyday charts that can help recognize current situation on the market. For example lower shadows you described on CAD/JPY; USDCHF.
I didn’t pay too much attention to lower shadows on my demo, took short trades with the thought of better price and it hit my stop loss. Luckily only on demo, so it’s good lesson.
Thank you.

hi chris
candlestick no.2 ( the bearish body ) on USD/CHF does not have long lower shadow. by your analysis i really do not know what size is long and what size do you call short shadow. please have a some clarify in this subject .
thanks

Hi chris
Thanks a lot for this nice article. There are something in the article. One is error type and the other is my questions
1-in the article end line just before conclusion there is an error type: ….. the price went up strongly while the market is too oversold . it seems it should be overbought.
2-Q1 :in EUR/USD daily chart at the last overbought the trend become reversed while we do not have divergence why?. In this case does it mean RSI not confirmed the strong setup? While in the same chart on example long trade setup we have RSI divergence.
3- Q2: I have learned a trend will reverse if we have divergence. Why a trend could be reversed while we do not have it?

2. Divergence forms when the candlesticks becomes smaller but still the price goes up while making the second high. In this case, still several long candlesticks formed while making the second high.

3. We never know. Even sometimes it doesn’t reverse when there is a strong divergence either with MACD or RSI or both. Price can change direction at any time and under any condition. All we can do is that we use the tools we have to get in the market if possible.

I read in another article about the RSI…that it is recommended to set the RSI setting to 8, then turn color to none, then, placed an 9 EMA within same indicator window set to react to the settings of the previously installed “RSI” indicator. I believe the writer stated this would smooth out the signal. I do not remember exactly, so, this is why I am asking…

Is this correct? If so, please, verify and or elaborate best way to setup RSI … Thank you …:)